Consumer prices rose sharply in July even as home foreclosures spiked, making it increasingly likely the economy will stall in the year’s last half under the weight of soaring unemployment, declining home values and accelerating inflation.

The Consumer Price Index (CPI) jumped 0.8% in July, the Commerce Department said yesterday (Thursday). On a year-over-year basis, the consumer prices climbed 5.6%, their biggest surge since 1991.

Usually, price levels decline in the face of slowing economic activity. But that’s not happening this time around. Indeed, soaring commodity prices are causing insidious inflationary forces to take hold, raising the possibility that the U.S. economy could be facing rampant stagflation for the first time since the 1970s.

Food and energy costs were two of the biggest CPI drivers, rising 0.9% and 4% respectively. Oil prices have declined substantially since hitting a record high $147 a barrel last month and gasoline prices have followed. But prices for both remain well above where they were a year ago, making the declines less meaningful. And there were other problem areas, too.

“If you thing things are going to get a lot better with the drop in petroleum prices, think again,” said Joel L. Naroff, president and chief economist of Naroff Economic Advisors Inc. in Holland, PA. “The increases were broad based…but the real eye opener was the jump in clothing prices. One month is hardly a trend, but with import prices jumping, we may be now seeing apparel adding to inflation rather than restraining it.”

Prices rose across the board with transportation costs up 1.7% and the clothes prices up 1.2%. Education and communication costs rose 0.5%.

Core prices, which exclude food and energy, rose 0.3% for the second straight month, and were up 2.5% from a year ago.

Import prices jumped 22% in the year ended July 31, the most since 1982, the Labor Department said yesterday.

Hobson’s Choice Time at the Federal Reserve

Soaring prices leave U.S. Federal Reserve policymakers with little room to maneuver in terms of altering interest rates to either jump-start growth, or thwart inflation.

It’s an unusual position to be in. While a cut in rates would push the economy into a higher gear, the lowered borrowing costs would fuel inflation. Conversely, while an increase in the benchmark Federal Funds rate would tamp down on inflation, the move also would strangle economic growth, possibly throwing the U.S. market into a deep recession.

“There’s less employment, there’s less wealth, and now banks are restraining credit,” Drew Matus, senior economist at Merrill Lynch & Co. Inc. (MER) said before the report. “We just don’t see where the consumer is going to get the money.”

Unemployment in the United States hit 5.7% in July – the highest level in four years. And the job market appears to be getting worse, as another 450,000 workers filed for jobless benefits last week. At the same time, the four-week moving average of new jobless claims climbed to 440,500 – the highest reading in more than six years.

In addition to being fired more, Americans are also earning less. Yesterday’s Commerce Department report showed a 0.8% decrease in wages, after adjusting for inflation. Wages declined by 0.9% in June, and are down 3.1% over the past 12 months – the biggest year-over-year decline since 1990.

“The large increases in consumer expenses means that household income is actually declining when adjusted for inflation,” said Naroff. “Confidence does not improve when the standard of living is declining. And with unemployment claims still quite high, we cannot expect much out of the consumer.”

A Rising Tide of Foreclosures

A towering wave of foreclosures and declining home values will also pose a major threat to economic growth in the last half this year.

“Bank repossessions, or REOs, continued to be the fastest growing segment of foreclosure activity in July,” said James J. Saccacio, chief executive officer of RealtyTrac. “The sharp rise in REOs, combined with slow sales, has resulted in a bloated inventory of bank-owned properties for sale.”

The more than 750,000 properties in RealtyTrac’s REO database represent 17% of the inventory of existing homes that were on the market in June, according to the Chicago-based National Association of Realtors.

Foreclosure filings, which include delinquency notices, auction sale notices, and bank repossessions, were up 55% on a year-over-year basis. Default notices increased by 53% from a year earlier and auction notices jumped 11%.

The second quarter of this year was the sixth consecutive quarter of declining home values. It was the largest year-over-year decline in 12 years, as home values plunged 1.7% from the first quarter and 9.9% from the year previous, Zwillow.comreported.

The median price tumbled to $206,500 from $223,500 a year earlier, the NAR said yesterday.

“It's getting worse,” Rick Sharga, RealtyTrac's executive vice president for marketing, told Bloomberg in an interview. “The number of properties that have been foreclosed on by the banks and still haven't sold is the highest we've ever seen.”

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